Aaoifi Fas 17 & Accounting Issues On Investments In Islamic Securities

Background of the Standard

The AAOIFI Financial Accounting Standard No. 17 (AAOIFI FAS 17) shall apply to the
institution’s investments, whether in the form of direct investment funds or investment
portfolios, in sukuk (Islamic bonds), shares, and real estate. The standard is relatively new
that is it shall only be effective for financial periods beginning 1 Muharram 1424H or 1
January 2003. Thus, it makes the discussion of this standard necessary especially for
institutions that have investments in Islamic capital market instruments. There is lack of
academic writings in this area that require special attention to ensure proper accounting for
complex instruments such as Islamic bonds (sukuk).
AAOIFI FAS 17 classifies Islamic bonds (sukuk) into at least four types:
(a) Mudaraba (Muqaradah) sukuk
These are investments in sukuk that represent ownership of units of equal value in the
Mudaraba equity and are registered in the names of holders on the basis of undivided
ownership of shares in the mudaraba equity and its returns according to percentage of
ownership of share. The owners of such sukuk are the rabbul-mal (capital provider).
(b) Musharaka sukuk
These are investments in sukuk that represent ownership of Musharaka equity. It does not
differ from theMudaraba sukuk except in the organization of the relationship between the
party issuing sukuk forms a committee from the holders of the sukuk who can be referred to
in investment decisions.
(c) Ijarah sukuk
These are sukuk that represent ownership of equal shares in a rented real estate or the usufruct
(benefit) of the real estate. These sukuk give their owners the right to own the real estate,
receive the rent and dispose of their sukuk in a manner that does not affect the right of the
lessee, i.e. they are tradable. The holders of such sukuk bear all cost of maintenance of and
damage of the real estate.
(d) Salam or Istisna’ sukuk
These are sukuk that represent a sale of a commodity on the basis of deferred delivery against
immediate payment. The deferred commodity is a debt in-kind against the supplier because
it refers to a commodity which is accepted based on the description of the seller. The Istisna’
sukuk is similar to Salam sukuk, except it is permissible to defer payment in an Istisna’
transaction, but not in a Salam. In both Salam and Istisna’, the subject matter of the sale is an
obligation on the manufacturer or builder in the case of Istisna’ and the seller in the case of
Salam. Hence both instruments can neither be sold nor traded before their maturity date if
either the buyer or the seller of the commodity issues them. Accordingly, these sukuk are
treated as investments held to maturity.
Classification of Investment
One notable contribution of AAOIFI FAS 17 is the classification of investment in sukuk into
three types namely: for trading purposes; available for sale; and held to maturity. The basis
of AAOIFI classification is based on the well-known syari’ah classification of trade
commodities for the purpose of zakat. For example, the jurists of Maliki School have
classified trading assets into the following: (a) assets that are meant for buying and selling;
(b) assets that are held for sale in the expectation of making profits through price appreciation
in the future; and (c) assets acquired not for trade, but for personal use.
However, if we examine the conventional classification of investment in securities, normally
it is only classified into 2 types i.e. either dealing (short-term); or investment (long-term).
The use of AAOIFI’s classification of investment into three types would be more desirable
and useful to users of accounting information as it provides an additional classification that
distinguishes the intention or purpose of investment. However, the main problem of
classifying the investments is to objectively determine the intention of the investors and
intention may also subject to change overtime due to the changes in economic climate.
Recognition
AAOIFI’s FAS 17 has recommended that recognition for investment in sukuk and shares
shall be recognized on the acquisition date and shall be measured at cost. However, at the end
of accounting period, investment in sukuk and shares held for trading purposes and available
for sale shall be measured at their fair value. The unrealized gains or losses as a result of re-
measurement need to be recognized in the income statement.
The additional requirement is the share of portion of income related to owners’ equity and
portion related to unrestricted equity investment account holders must be taken into
consideration. This is considered crucial as no proper treatment and disclosure of this
transaction of profit sharing and distribution may lead to confusion as to the method, ratio
and process to disburse profit that have been taken place. This is to ensure transparency in
profit and loss sharing on re-measurement of investment at the end of the year to be properly
disclosed to the users. At the same time it fulfils the syari’ah requirement of ensuring fair and
just profit sharing and distribution between shareholders and depositors (investors).
 Any unrealized gain or loss resulting from re-measurement at fair value, according to
AAOIFI FAS 17 shall be recognized in the statement of financial position under the
“investment fair value reserve”. This reserve account will reflect the net gain or loss at the
end of the year. The standard also makes a provision that in case the institution has reserves
created by appropriation of profits of previous financial periods to meet future investment
risks, it is recommended that unrealized loss resulted from re-measurement of investment at
fair value shall be deducted from this reserve.
Measurement
In the case of sukuk held to maturity, it needs to be measured based on historical cost except
that if there is impairment in value it should be measured at fair value. The difference in value
will then need to be recognized in the income statement and the information related to the
fair value is then need to be disclosed in the notes to the financial statements. For securities
held for trading and available for sale, AAOIFI FAS 17 recommends the measurement to be
based on fair value.
Fair value is normally defined as the amount which the instrument could be exchanged or
settled between knowledgeable and willing parties in an arm’s length transaction, other than
forced or liquidation sale. Quoted market price, when available, normally are used as the
measure of fair values. However, for many financial instruments and it may include Islamic
bonds (sukuk), quoted market prices may not available.
In the case of unquoted securities, conventionally the estimate is based on the net present
value or other valuation techniques. However, these techniques involve uncertainties and are
significantly affected by the assumptions used and judgments made regarding risk
characteristics of various financial or capital market instruments. The uncertainties include
the arbitrary used of discount rates, future cash flows, expected loss and other factors.
The determination of fair value for unquoted securities requires the availability of objective
indicator and expertise, as well as conservatism in the valuation process. The objective of
Islamic valuation should be to provide both relevant and reliable value that can be relied on
by the users of financial statements to make useful judgment and decision (El-Tegani,
undated).
In the case of securities held to maturity, the rationale of AAOIFI’s FAS 17 to recommend
historical cost rather than fair value could be because of the inherent uncertainties in relation
to the use fair value for capital market instruments. Another reason could be because there is
no intention to trade in the securities before maturity, thus, there is no apparent need to
measure the securities at the end of the year at fair value.
The AAOIFI’s FAS 17 also prescribes that the realized profits or losses resulting from sale
of any investment shall be measured at the difference between the book value and the net
cash proceeds from the sale of investment. The standard also makes recommendation that
different types of investment must be shown separately according to the three classifications
as defined earlier. This is important to give a better picture of profit resulted from different
types of investment. This recommended treatment is also necessaryto assist users in
determining and comparing profitability between different types of investment.
In the case of dividends received from investment in shares and sukuk, the standard requires
it to berecognized in the income statement at the declaration date rather than at the date when
the cash proceed is received. This indicates the use of accrual basis of accounting to ensure
that the institution recognized income when it is realized based on the contract or the right to
receive that income. The use of accrual here is required in order to reflect the actual or fair
income at that point when it is realized.
The additional requirement of realized profit from sale of investment and dividends received
is the need to distinguish between the portion to be shared by owners’ equity and depositors
(investors). The rationale is similar to the case of treatment of profit on re-measurement of
investment at fair value as discussed above, as it will ensure sufficient information to be
provided to users of accounting information particularly on the distribution of profit between
equity holders and depositors.
Disclosure
AAOIFI’s FAS 17 has made special requirements of disclosure in the case of investments in
sukuk. Among the requirements are that disclosure shall be made by the issuer of sukuk, if
material, the face value of sukuk, the percentage of sukuk acquired from each party issuing
the sukuk and each type of sukuk. There is also a requirement to disclose the party
guaranteeing the sukuk and the nature of the guarantee. Another useful disclosure
requirement is the need to disclose the contractual relationship between the issuer and/or
manager of sukuk and the holders of such sukuk. The additional disclosure with respect to
investment in sukuk is the requirement to disclose the classification of sukuk according to
their maturities.
All the above disclosure requirements indicates the need for the Islamic institutions to be
more transparent in disclosing financial information pertaining investment in securities
especially sukuk. The underlying rationale is to provide useful information for users to make
informed judgement especially about institution’s investment in securities. The users are
expected to require all the above information and disclosure not only with respect to the risks
of investment undertaken and the potential return (full disclosure) but the contractual
relationships of the parties involved that is expected to fulfill the syari’ah requirements (social
accountability). International Journal of Islamic Financial Services, Vol.4, No.4
6. Concluding Remarks
The need for Islamic accounting that deals with Islamic financial instruments has prompted
AAOIFI recently to introduce Financial Accounting Standard No.17 on investments in
securities. The need for a codified Islamic accounting standard are primarily stemmed from
the need that Islamic accounting objectives, concepts and principles to be developed based
on syari’ah requirements. However, the Islamic accounting regulation also needs to adapt to
the modern accounting regulatory environment to make it relevant to be practiced in our time.
The examination of AAOIFI FAS 17 shows that AAOIFI has been pragmatic in its approach
by considering both requirements when developing its standard. This is a pro-active step to
provide a sound accounting regulation as part of a comprehensive regulation of Islamic
financial institutions.
The development of modern accounting has shown that accounting itself is an emerging and
pragmatic discipline. Another paramount challenge and conventional accounting is of no
exception, is compliance of the standard. For the standard to be adopted by commercial
participants, the regulatory agencies of respective Muslim states at least must be convinced
not only for the need of such standard but the necessity to adopt it as a mandatory requirement.
Another pre-requisite for a sound accounting regulation is the credibility of standard setter.
In the case of AAOIFI, the credibility of its standard will be subjected to ‘acid’ test of
acceptance by commercial participants especially Islamic financial institutions. In addition,
another challenging task would be the acceptance of juristic rules made by AAOIFI’s board
of syari’ah scholars by Islamic financial institutions worldwide. As syari’ah opinion can be
subjected to vast differences among scholars, this leads to another need that is a standard or
a codified syari’ah rules based on consensus of credible Muslim scholars of our time that
transcends beyond geographical boundaries of nation states.
Finally, the development of a new discipline called Islamic accounting establishes an urgent
need for the accounting academics and practitioners to undertake studies that attempt to
understand how accounting is influenced by and adapted to the way the economic system is
organized and the philosophy underpinning its system. The interests on Islamic accounting
has been growing for the past two decades, however, the development of Islamic accounting
is still at the infancy stage. This paper is just a small contribution to the literature on
contemporary accounting regulatory issues on investments in Islamic bonds or sukuk.
AAOIFI accounting for the sukuk transaction
AAOIFI does not have a specific accounting standard for sukuk.

Unlike IFRS, "Statement of Financial Accounting No. 1: Objectives of Financial Accounting

for Islamic Banks and Financial Institutions" mentioned above does not have any overriding
concept of substance. Nor does "Statement of Financial Accounting No. 2 (Amended):
Concepts of Financial Accounting for Islamic Banks and Financial Institutions" also adopted
in 1993.

However AAOIFI has recently redrafted these statements in July 2010 to take account of
substance, to give it recognition in addition to recognising the importance of the legal form
of the contract. However, there is an overriding requirement to make sure that if substance
and form are in conflict Shariah shall prevail.

Given the importance of demonstrating to the users of the accounts that the transactions
comply with Shariah, in the writer’s opinion under AAOIFI the financial statements would
be prepared as below. The key differences between the following AAOIFI accounts and the
IFRS accounts are as follows:

Footnote
When the building was sold on 31/12/2015, the entire sale proceeds of £110 were distributed
to the sukuk holders as the investment fund was dissolved at that time.

In the writer’s view, as well as preparing its own accounts as SPV, accounts should be
prepared for the investment fund represented by the sukuk in accordance with Financial
Accounting Standard 14 "Investment Funds" and that these are also shown above.
For comparability, Trader plc is shown as distributing only the same amount of profit each
year as a dividend to its shareholders as it distributes under IFRS accounting. (The amount to
distribute is a management decision and Trader plc is not required to distribute all of its post
tax profit.) Accordingly, Trader plc's cash balances are the same as under the IFRS scenario.
The key difference is that over the five-year period Trader plc records £10 less in total
expenses and at the end of the period it reports the purchase of the building for £110 whereas
under IFRS the building remains on Trader plc's balance sheet throughout at £100.

Which is right?
This is not a meaningful question. IFRS and AAOIFI accounting have different objectives
and perspectives.

IFRS analyses the sukuk transaction entirely on the basis of its economic substance and sees
it as a financing transaction. Fundamentally, this derives from the requirement to repurchase
the building at a fixed price irrespective of the market value.

As an alternative, if the sukuk transaction required Trader plc to repurchase the building at
the open market value on the date of repurchase (which totally changes the economics of the
transaction) then Trader plc would record only £5 of rental expense each year, and it would
de-recognise the building when sold to the SPV since from that point Trader plc would have
no economic exposure to value changes in the building.

The main purpose of AAOIFI accounting is to satisfy the religious needs of the users of the
accounts. Accordingly AAOIFI does not allow substance to determine the presentation of the
accounts but instead gives significant weight to the legal form of contracts and Shariah
requirements are overriding.

The future of AAOIFI accounting standards

When AAOIFI was established, global accounting was very fragmented. Although
international accounting standards existed, most countries required the use of local
accounting standards and in the countries of the Gulf accounting standards were nascent or
non-existent. Accordingly AAOIFI played an important standard setting role in the Islamic
finance industry at that time.

In 2010 the picture is very different. Outside a few countries in the Gulf and the USA,
virtually the entire world accounts under IFRS. The last significant holdout is USA but there
is a convergence project between the US Financial Accounting Standards Board and the IASB
to converge IFRS and US GAAP (Generally Accepted Accounting Principles). Accordingly,
Islamic financial institutions in all parts of the world apart from some Gulf countries will be
accounting under IFRS very shortly if they do not already do so.

In these circumstances, there is little point in AAOIFI continuing to promulgate accounting

standards. Instead, it should focus on Shariah standards where AAOIFI's role is critical. As
far as accounting is concerned, AAOIFI should encourage the IASB to ensure that the needs
of Islamic users of financial statements are met by IFRS. This would include such matters as
additional footnote disclosures so that investors knew what proportion of a company's
dividend payments represented impure income, what part of its retained earnings were impure
and which of the company's assets were liable to Zakah. Islamic investors would like to have
such information in respect of the financial statements of all publicly traded companies, with
the exception of those companies carrying on wholly prohibited activities such as alcohol
distribution.
Example 10.1:
Islamic Bank A invested in the following securities in terms of shares:
Company A Company B Company C
(Ordinary Shares) (Ordinary Shares) (Ordinary Shares)
Acquisition Date 1 Feb. 2006 20 May 2008 1 January 2000
Types Held-for-trading Available-for-sale Held-to-maturity
Acquisition price
per share RM2.00 RM15 RM1.00
Quantity of shares 700,000 units 1,000,000 units 500,000 units
Quoted price per share
on 30 June 2009
RM1.50 RM18 RM2.00
Islamic Bank A also invested in the following sukuk issued by the following companies/
sovereign government:
Company D Company E Government A
(Mudarabah Sukuk) (Istisna’ Sukuk) (Ijarah Sukuk)
Acquisition Date 1 Feb. 2006 1 July 2000 11 September 2005
Types Held-to-maturity Held-to-maturity Held-to-maturity
Acquisition price
per share RM20.00 RM15 RM1.00
Quantity of shares 1,500,000 units 1,000,000 units 500,000 units
Maturity date 1 January 2010 30 June 2009 11 September 2020
Required:
(a) Prepare journal entries to recognise the above investment in securities for both shares and
sukuk according to AAOIFI FAS 17. The profit realised on 30 June 2009 for sukuk invested
in Company E is RM10 per share.
(b) Prepare investment in fair value reserve account as at
30th June 2009
(c) Islamic Bank A has agreed that on 30th. June 2009, 30%
of the balance of the investment in fair value reserve account will be distributed according to
the following profit sharing ratio of 80: 20 between shareholders and depositors. The balance
of the investment in fair value reserve account on 1st of July 2008 was RM2,400,500.
Suggested Solution:
Part (a)
Company A Shares On 1 Feb 2006:
Dr . Investment in Securities account (2.00 x 700,000 units) - 1,400,000
Cr. Cash account - 1,400,000
(Being investment in Company A shares)
On 30 June 209:
Dr . Profit and Loss account – unrealised loss (0.50 x7 00,000 units) 350,000
Cr. Investment in Securities account - 350,000
(Recognition of unrealised loss in Company A shares)
Dr. Investment Fair Value Reserve account - 350,000
Cr. Profit and Loss account – appropriation - 350,000
(Transfer investment unrealised loss to reserve)
Company B Shares
On 20 May 2008:
Dr . Investment in Securities account (15.00 x 1,000,000 units) - 15,000,000
Cr. Cash account - 15,000,000
(Being investment in Company B shares)
On 30 June 2009:
Dr . Investment in Securities account (3.00 x 1,000,000) 3,000,000
Cr. Profit and Loss account – unrealised gain - 3,000,000
(Recognition of unrealised gain in Company B shares)

Dr . Profit and Loss account – appropriation - 3,000,000

Cr. Investment Fair Value Reserve account - 3,000,000
(Transfer investment unrealised gain to reserve)
Company C Shares
On 1 Jan 2000:
Dr . Investment in Securities account (1.00 x 500,000 units) - 500,000
Cr. Cash account - 500,000
(Being investment in Company C shares)
On 30 June 2009:
Dr . Investment in Securities account (1.00 x 500,000) 500,000
Cr. Profit and Loss account – unrealised gain - 500,000
(Recognition of unrealised gain in Company C shares)
Dr . Profit and Loss account – appropriation - 500,000
Cr. Investment Fair Value Reserve account - 500,000
(Transfer unrealised gain to reserve)
Company E Sukuk
On 1 July 2000:
Dr . Investment in Securities account (15 x 1,000,000) 15,000,000
Cr. Cash account - 15,000,000
(Being investment in Company E sukuk)
On 30 June 2009 (Maturity Date):
Dr . Cash account - 15,000,000
Cr. Investment in Securities - 15,000,000
(Disposal of sukuk at maturity)

Dr. Cash account (profit from investment in sukuk as

promised) – RMXXX
Cr. Profit and Loss account - RMXXX
(Recognition of profit on investment in sukuk )
Note: Gain from held-to-maturity sukuk will be distributed to equity holders and depositors
depending on the Islamic bank’s policy but it must be transparent.
Company D & Government A Sukuk
Not matured yet and thus, no transaction. It will appear in the Balance Sheet at cost since
these securities are held-tomaturity.
Part (b) and (c):
Dr. Investment Fair Value Reserve a/c Cr.
FV Shares – Co. A 350,000 1/7/08 Balance b/d 2,400,500
P&L a/c * 1,770,150 FV Shares - Co. B 3,000,000
30/6/09 Balance c/d 4,130,350 FV Shares - Co. C 500,000
5,900,500 5,900,500
* Total profit distributed on 30 June 2009 = 5,900,500 x30% = 1,770,150
Share of profit for depositors = 1,770,150 x 0.2 = 354,030
Share of profit for shareholders = 1,770.150 x 0.8 = 1,416,120
The above profit distribution is accounted for through Investment Fair Value Reserve
account. The profit sharing ratio of the distributable profit must be clearly stated in the
financial statement. Transparency of the profit sharing and distribution process is required to
ensure true and fair profit distribution as required by the Shari’ah.